7/29/2019 Dividend Policy in Corporate Finance And Investments

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Dividend Policy

As the Financial system's capital was being depleted, many banks continued to pay dividends

well into the depth of the 2007-2009 Financial crisis. Large bank holding companies such as

Bank of America, Citigroup and JP Morgan maintained a smooth dividend behavior, while

securities companies such as Lehman Brothers and Merrill Lynch even increased their dividendsas losses were accumulating. This behavior represents a type of risk-shifting or asset substitution

that favors equity holders over debt holders.

We present a simple model where, in the presence of risky debt, risk shifting incentives can

motivate the payment of dividends as observed during the crisis. In our model, the bank has

assets in place that generate some cash ow in the current period and some uncertain cash flow

in the next period. At any given point in time, the bank has a franchise value (say, the present

value of all its future cash ows) that is largely determined by the relationship with its customers

and counterparties. The bank can pay dividends out of the current cash ow, and carry the

remaining cash to the next period. The bank has to fulfill non-negotiable debt obligations in thenext period out of the next period's cash flow and cash savings from the current period. If debt

obligations are not satisfied, the bank is in default. In this case, equity holders receive no value

from the next period cash flow, and furthermore, the bank's franchise value is lost, for example,

through a disorderly liquidation or transfer to another bank or government.

Given this setup, the first best solution that maximizes the total equity and debt value of the

bank is to pay zero dividends. This is because risk shifting will decrease the total value of the

bank by increasing the probability that its franchise value will be lost. Any gain from risk shifting

by the bank's equity holders is a loss to its creditors in a zero sum game. However, we show that

in practice when the dividend policy of a bank is set to maximize its equity holders' value, the

optimal dividend policy can stray away from the first best solution. Here, the dividend policy

reflects a tradeoff between (i) paying out to equity holders the available cash today rather than

transferring it to creditors in default states in the future; and (ii) saving the equity's option on

the franchise value since dividend payout raises the likelihood of default and thus foregoing

this value.